Stocks: Here Comes the Capital Spending…Maybe

By Ben Levisohn

For much of the economic recovery, companies like have refused to spend–and they’ve been rewarded for it. Could that be changing?

Bloomberg

Barclays’ Scott Davis and team believe it might be, and for evidence they look at 3M (MMM), Emerson Electric (EMR), Rockwell Automation (ROK), and MSC Industrial Direct (MSM). They write:

What’s been glaringly missing from this cycle has been any signs of business confidence at levels that traditionally drive investment spending. This quarter is the first quarter where we have seen signs of a turn here…

The key signs that we saw this quarter specifically relate to rising levels of investment amongst the companies that we cover, in particular 3M, Emerson Electric, Rockwell Automation, and MSC Industrial Direct. The importance here is that we see higher levels of growth investment through the value chain beginning at the R&D level, then manufacturing, and lastly distribution. Raw material/mining investment remains highly depressed and is the one area where we may not have seen the bottom yet. Otherwise though, it seems we are tracking for 2014 capex to rise for the first time since we had our initial recovery pop from trough levels in 2010-2011.

The big question now will be how investors react to that pickup in capital spending, Davis says:

The early read is mixed. Shareholders have seemed to lose patience with companies whose investment cycle seems overly extended, aggressive, or risky. For example, many shareholders have exited MSM as its investment strategy became clearer and more dilutive all the while that growth was slowing. On the other hand, investors in both 3M and EMR have taken things in more balanced stride, willing to take higher growth levels as a payback for bigger spend. It’s a tricky situation because statistically companies who are able to raise margins and ROIC the most are more likely to have stocks that outperform peers. But there are examples of companies that have invested heavily, driven to higher growth levels, and been able to more than offset the higher spend with operating leverage from the higher volume growth. Distributors W.W. Grainger (GWW) and Fastenal (FAST) are two notable examples.

Morgan Stanley’s Adam Parker and team explain that the market might be starting to punish companies unwilling to spend. They write:

Last month, high capital spenders (normalized by sales) had their best risk-adjusted performance in at least 25 months, and their first outperformance in 2013 (Exhibit ). On a raw basis, high capex/sales firms outperformed for only the second time this year. The spread was driven mainly by the underperformance of low capital spenders.

The outperformance of high capital spenders was quite strong (the most since 2011) – although it was actually more a case of low spenders underperforming – and bears watching, as company managements pay attention to the market’s reaction to capital spending.

About Stocks To Watch

Earnings reports, corporate strategies and analyst insights are all part of what moves stocks, and they’re all covered by the Stocks to Watch blog. We also look at macro issues, investor sentiments and hidden trends that are affecting the market. Stocks to Watch gives you the full picture of the U.S. stock markets, all day long.

The blog is written by Ben Levisohn, a former stock trader who has covered financial markets for the Wall Street Journal, Bloomberg and BusinessWeek.